When analyzing asset protection for self-directed IRAs, we must consider two types of potential threats. First, we must examine how a creditor can collect against an IRA when the creditor has a judgment or claim against the IRA owner personally. Second, and most importantly for self-directed IRA owners, we must analyze how a creditor can collect against an IRA or its owner when the IRAs investment incurs a claim or judgment.
There has been much written on the protections to retirement plans that prevent a creditor of the IRA owner from collecting against the IRA to satisfy their judgment. Various federal and state laws provide this protection which prohibits a creditor of an IRA owner from collecting or seizing the assets of an IRA or other retirement plan. For example, if an individual personally defaults on a loan in their personal name and then gets a judgment against them, the creditor may collect against the individual’s personal bank accounts, non-retirement plan investment accounts, wages, and other non-exempt assets but is prohibited from collecting against the IRA or other retirement plans of the individual. Even in the case of bankruptcy, a retirement plan is considered an exempt asset from the reaches of the creditors being wiped out. US Bankruptcy Code, 11 USC §522. Because of these asset protection benefits, retirement plans are excellent places to hold assets outside the reach of creditors.
The second asset protection issue, and the focus of this article, is to consider how an IRA is protected from claims arising from the IRA’s investments and activities? This issue is particularly important to self-directed IRA accounts since some self-directed IRA investments are made into assets that can create liability to the IRA, and the protections preventing a creditor of the IRA owner against the IRA assets do not apply to liabilities arising from the IRAs investments. In other words, if the IRA has a liability, the IRA is subject to the claims of creditors. For example, if a self-directed IRA owns a rental property and the tenant in that property slips and falls, the tenant can sue the self-directed IRA who owned and leased the property to the tenant. Consequently, the IRA’s assets are subject to the collection of the creditor, including the property the IRA owned and leased to the tenant as well as the other assets of the IRA. But what about the IRA owner and their personal assets, are their personal assets also at risk?
Let’s analyze this issue further and look at whether a creditor/plaintiff against the IRA can also sue the IRA owner personally if the IRA’s assets are not sufficient to satisfy the judgment against the IRA. IRC § 408 states that an IRA is a trust created when an individual establishes an IRA by signing IRS form 5305 (this form is completed, with some variations, with every IRA) with a bank or qualified custodian. Courts have analyzed what an IRA is under the law and have stated that they are a trust or special deposit of the individual for the benefit of the IRA owner. First Nat’l Bank v. Estate of Thomas Philip, 436 NE 2d 15 (1992). In other words, the IRA is not a separate entity or trust which would be exempt from creditor protection of its underlying owner. Since the IRA is a trust that is revocable and terminated at the discretion of the IRA owner, each investment in fact, is truly controlled by the IRA owner as he or she could terminate the IRA at any time and take ownership in their personal name. As a result, the IRA is akin to a revocable living trust used for estate planning which trust is commonly understood by lawyers and courts to provide no asset protection and prevention of creditors from pursuing the trust creator and owner from liabilities and judgments that arise in the trust. Following this same rationale, a self-directed IRA would likely be subjected to a similar downfall in the event of a large liability that is not satisfied by the assets of the IRA. As a consequence, the personal assets of the IRA owner may be at risk.
As a result of the asset protection liabilities for self-directed IRAs, we recommend that self-directed IRA owners consider an IRA/LLC for the asset protection reasons that many individuals use LLCs in their personal investment and business activities. Simply put, an LLC prevents the creditor of the LLC from being able to pursue the owner of the LLC (in this case, the IRA). An IRA/LLC is an LLC owned typically 100% by the IRA, and the LLC would operate and take ownership of the investments and the liabilities similar to an LLC used by an individual. For example, instead of the IRA taking ownership of a rental property directly and leasing it to a tenant, the IRA/LLC would instead take title to the property and would lease the property to the tenant. When the IRA/LLC owns and leases the property, any claims or liabilities that arise are contained in the LLC, and as a result of the LLC laws, a creditor is prevented from going after the LLC owner (in this case, the IRA, or the IRA owner).
There are certain types of self-directed IRA investments that benefit greatly from the asset protection offered by an IRA/LLC. Rental real estate owned by an IRA achieves significant asset protection benefits from an IRA/LLC since rental real estate can create liabilities to its owner. Other self-directed IRA investments such as promissory note loans, precious metals, or land investments do not have the same asset protection issues and potential to create liability for the IRA, and as a result, an IRA/LLC isn’t as beneficial from an asset protection perspective for these types of investments.